Sale of Shares and the Legal Warranty of Quality: Protection Excluded

Assets or Shares: A Critical Distinction

The recourse based on the legal warranty of quality is a legal mechanism frequently used in the context of asset sales, particularly real estate transactions. A typical example would be an undisclosed water infiltration discovered after the purchase of a building.

Quebec courts have consistently held, however, that the warranty of quality does not apply to the sale of shares[1], even where the defect affects the corporation’s principal asset, such as the building from which it carries on its business.

This distinction stems in part from the fact that shares are incorporeal property[2], whereas the warranty of quality is primarily designed to protect the use of corporeal property, a concept that is not easily transposed to incorporeal property. In addition, the sale of shares does not transfer ownership of the corporation’s property to the buyer, unlike the sale of a building, which results in a change of ownership.

That said, the impacts of this limitation can often be mitigated, or avoided altogether, through the inclusion of representations and warranties by the seller of the shares relating to the company’s assets.

The Extent of the Defect: A Possible Exception?

But what happens when a defect affecting the corporation’s assets is so serious that it undermines the company’s ability to carry on business?

Although Quebec courts do not appear to have addressed this issue directly, French courts have, in certain exceptional circumstances, extended the warranty of quality to the sale of shares where a latent defect effectively jeopardized the operation of the target company’s business. In other words, French courts[3] have occasionally found that the shares themselves had become unfit for their intended purpose, or that their value and utility had been substantially diminished, because the company could no longer continue its operations as a result of the latent defect affecting one or more of its assets.

Given the close similarity between the provisions of the French Civil Code[4]and those of the Civil Code of Québec[5] governing the legal warranty of quality, it is conceivable that Quebec courts could adopt a similar approach should the issue ever come before them.